Meet John, a supermarket manager who is married with three school-age children and takes home a comfortably large paycheck. Sure he has some credit card debts and a couple of car loans, but he never misses a payment and assumes that getting a mortgage for a new home should be a piece of cake.
Then comes the bad news. After visiting several banks with a fat folder of financial documents, John is told he’s above the 43% Rule and can’t borrow the money.
It’s a ratio of debt-to-income, and a crucial standard for deciding who qualifies for a loan and who doesn’t.
In reviewing loan applications, lenders compute the ratio of a person’s debt relative to income. The standard for qualifying for a home loan is 43 percent, though it might vary a bit from lender to lender. If monthly debt payments exceed 43 percent of calculated income, the person is unlikely to qualify, even if he or she pays all their bills on time.
For other types of loans – debt consolidation loans, for example — a ratio needs to fall between 36 and 49 percent. Above that, qualifying for a conventional loan is unlikely.
The debt-to-income ratio surprises a lot of loan applicants who always thought of themselves as good money managers. Whether they want to buy a house, finance a car or consolidate debts, the ratio determines whether they’ll be able to find a lender.
Your debt-to-income ratio compares the amount of your debt (excluding your mortgage or rent payment) to your income. The ratio is best figured on a monthly basis. For example, if your monthly take-home pay is $2,000 and you pay $400 per month in debt payment for loans and credit cards, your debt-to-income ratio is 20 percent ($400 divided by $2,000 = .20).
Put another way, the ratio is a percent of your income that is pre-promised to debt payments. If your ratio is 40%, that means you have pre-promised 40% of your future income to pay debts.
So the trick for many would-be-borrowers is a budget before they go shopping for a loan. Lowering a debt-to-income ratio can be the difference between a dream fulfilled and rejection.
Calculating your debt-to-income ratio in easy 4 steps:
The goal is 43% or less, and lenders often recommend taking remedial steps if your ratio exceeds 36%. There are two options to improving your debt-to-income ratio:
Neither one is easy for many people, but there are strategies to consider that might work for you.
For most people, attacking debt is the easier of the two solutions. Start off by making a list of everything you owe. The list should include credit-card debts, car loans, mortgage- and home-equity loans, homeowners’ association fees, property taxes and expenses like internet, cable and gym memberships. Add it all up.
Then look at your monthly payments. Are any of them larger than they need to be? How much interest are you paying on the credit cards, for instance. Consider consolidating debt: moving high-interest credit card balances to lower interest ones. Many card companies actually offer incentives, like no-interest grace periods on transfers, so explore the options.
Remember that improving your DTI ratio is based on debt payments, and not debt balances. You can lower your debt payments by finding a debt solution with lower interest rates or a longer payment schedule. Lowering your monthly debt payments can help you improve your ratio and qualify for a loan.
Other alternatives to consider to lower your expenses and pay off debt:
Most important, make a realistic budget designed to lower your debt and stick with it. Once a month, recalculate your loan-to-income ratio and see how fast it falls under 43%.
Improving the income side always is more difficult because it requires the one thing no one has enough of – time. Finding a night-time or weekend job that produces even a couple of hundred dollars could be the difference maker in getting your debt-to-income ratio below 43%.
Finding a combination of the two – part-time job, plus reducing expenses – is the ultimate solution and might even bring your debt-to-income ratio down below the 36% level that lenders are anxious to do business with.
Keeping track of your debt-to-income ratio can help you avoid “creeping indebtedness,” or the gradual rising of debt. Impulse buying and routine use of credit cards for small, daily purchases can easily result in unmanageable debt. By monitoring your debt-to-income ratio, you can:
Creditors look at your debt-to-income ratio to determine whether you’re creditworthy. Letting your ratio rise above 20 percent may:
Debt-to-income ratios are powerful indicators of creditworthiness and financial condition. Know your ratio and keep it low.
The lower your debt-to-income ratio, the better your financial condition. You’re probably doing OK if your debt-to-income ratio is lower than 19%. Though each situation is different, a ratio of 20% or higher is a sign of a credit crisis. As your debt payments decrease over time, you will spend less of your take home pay on interest, freeing up money for other budget priorities, including savings.
Irby, L. (2016, June 8). How to Lower Your Debt-to-Income Ratio. Retrieved from: http://credit.about.com/od/reducingdebt/qt/lowerdebtratio.htm
Schreiner, E. (ND) How to Lower Your Debt Ratio. Retrieved from: http://budgeting.thenest.com/lower-debt-ratio-3921.html
Emisar, O. (2011, September 8) 10 Tips for Improving Your Debt to Income Ratio. Bright Hub. Retrieved from: http://www.brighthub.com/money/personal-finance/articles/121853.aspx
NA, ND. Understanding Your Debt-to-Income Ratio. Retrieved from: https://www.bankofamerica.com/credit-cards/education/what-is-debt-to-income-ratio.go